IRR is abbreviation of Internal Rate of Return. IRR means discount rate
when NPV is 0. IRR is often used with DCF method.
An example of IRR
There are two 100K USD investment ideas. Idea A can earn 20K USD every year and facility is sold in the final year. Idea B can earn 3K USD every year and get back 100K USD in the final year. These ideas can get total 112K USD of cash so it seems that these bring same return for the company.
However, if discount rate is applied to these ideas, these will bring different return. Let's say discount rate is 3%.
In this discount rate, each NPV is as follows.
In terms of IRR, each result is follows.
IRR of Idea A is 0.98% higher than that of Idea B.
This result is shown by graph as below.
Disadvantages of IRR
IRR has an advantage to be discussed in terms of yield rate, however, it also has disadvantages below.
IRR doesn't mention amount of cash.
IRR doesn't have clear period to be discussed.
IRR sometimes cannot be calculated.
IRR cannot be applied when discount rate is changeable, for example, M&A or selling business which causes significant D/E ratio change. It brings big change of WACC
@In case that IRR cannot be calculated@
If there is minus FCF in middle of period, IRR sometimes cannot be calculated.
@Which is better, NPV or IRR?@
As above, IRR has some disadvantages so it should be considered with NPV. Generally speaking, following criteria can help us to use NPV or IRR.
In case that the company doesn't have few limitations to use money, NPV is better
In case that the company should consider limited money and allocate investment cost to several ideas, IRR is better.
@Calculating IRR by Excel@
IRR can be calculated by excel easily as below. IRR formula brings IRR at 1 year span. If you want to clarify IRR at dairy, you can XIRR formula.
Principle of Finance FCF (Free Cash Flow) DCF (Discount Cash Flow) WACC Beta Unlevered Beta IRR Terminal Value Disadvantages of WACC APV (Adjusted present value) Method
Making Portfolio and Diversification of Risk 1
Making Portfolio and Diversification of Risk 2
Return analysis by DCF 1
Return analysis by DCF 2
Important Indicator of DCF
Optimized Debt Equity Ratio
Tax Shield by Debt
Types of Debt
Policy of Dividend
Relationship between Policy of Dividend & Stock Price
Relationship between Own Shares Purchase & Stock Price
Investment to raise Stock Price
Bond with Warrant
Comparison of Yield Rate among Several Bonds
Effect of M&A
Financing in M&A
Process of Purchasing Stock Price in M&A
Types of Selling Business
LBO (Leveraged Buy Out)
MBO (Management Buy Out)
PPA (Purchase Price Allocation)
PMI (Post Merger Integration)